What’s become popular in the buy-sell/M&A world is a Quality of Earnings (QofE) report. It’s a deep dive into the financial statements to see if there are any abnormalities. In other words, are the income statement and balance sheet a true reflection of the business?
What does it look for? Things like:
- Non-recurring income. If assets were sold at a profit it’s not quality earnings.
- Non-recurring expense. Real life situation: a client has a legal settlement from eight years ago. This is not a current operational expense.
- Are there excessively high or low salaries needing to be adjusted to market?
- Are there customer or supplier risks like a sole source supplier or a customer with 10 buying units but one department could end all 10 immediately?
We recently had the following with a client who does cash basis accounting. A large sale at the end of 2023 resulted in payments in 2024. It means 2024 income was noticeably lower and 2023 was much higher than reported. Some would use this to renegotiate the deal. Luckily for our client the buyer is sticking with the original deal.
Some say you don’t need a QoE unless it’s a huge deal. There are different levels of them and the above shows what they can uncover. FYI, two of them for our clients in 2024 came back 100% clean, as did the above example other than timing of revenue.
“Just be glad you’re not getting all the government you’re paying for.” Will Rogers
“Mistakes are the portal of discovery.” James Joyce